This paper establishes the prevailing financial factors that influence credit spread variability, and its impact on the U.S. business cycle over the Great Moderation and Great Recession periods. To do so, we develop a dynamic general equilibrium framework with a central role of financial intermediation and equity assets. Over the Great Moderation and Great Recession periods, we find an important role for bank market power (sticky rate adjustments and loan rate markups) on credit spread variability in the U.S. business cycle. Equity prices exacerbate movements in credit spreads through the financial accelerator channel, but cannot be regarded as a main driving force of credit spread variability. Both the financial accelerator and bank capital channels play a significant role in propagating the movements of credit spreads. We observe a remarkable decline in the influence of technology and monetary policy shocks over three recession periods. From the demand-side of the credit market, the influence of LTV shocks has declined since the 1990-91 recession, while the bank capital requirement shock exacerbates and prolongs credit spread variability over the 2007-09 recession period. Across the three recession periods, there is an increasing trend in the contribution of loan markup shocks to the variability of retail credit spreads.
Credit spread variability in U.S. business cycles: The Great Moderation versus the Great Recession
Working paper 454
Journal of Banking & Finance
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